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Where next for high- frequency FX trading

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					                                                                                                                               Opinion


Where next for high-                                                                         the issues raised by senator Kaufman and
                                                                                             others about the activities of HFT in the

frequency FX trading?
                                                                                             US equity markets were the following:
                                                                                             ■ HFT comprises more than 70% of
                                                                                             equity trading.
                                                                                             ■ HFT creates message traffic and ticket
Regulation established in the wake of the financial crisis to                                counts that cause infrastructure problems.
promote market integration, together with new norms being                                    ■ HFT activity has contributed to the
considered for high-frequency trading in equity markets,                                     creation of more than 50 trading plat-
                                                                                             forms, which has fragmented liquidity
may unnecessarily complicate the FX market, says Chip                                        and driven volume to opaque dark pools.
Lowry, chief operating officer at Currenex, part of the State                                ■ This fragmentation has led to a veneer
Street Global Markets division of State Street in New York                                   of liquidity in the lit markets, which
                                                                                             allowed the flash crash to happen... and
                                                                                             could possibly allow it to happen again.
                                                                                               HFT is well-embedded into the fabric of
The global market for currency and              pate in it, transactions related to spot     the FX market. In fact, it is arguable that
related derivatives, comprised of three         currency, forwards and swaps are part of     it is in the trading of currencies that HFT
mutually supportive markets for spot            a unitary structure and therefore should     has played its most dynamic and produc-
currency, forwards and swaps, is the            be subject to unified regulation.            tive role in the generation of liquidity and
world’s largest, and most liquid. Not-                                                       market-making. But the inclusion of FX
withstanding its vast size, the FX market       High-frequency trading                       forward and swap trading into a new reg-
has operated for decades with relatively        Today, with Mifid still fresh and the ink    ulatory regime aimed to ameliorate issues
few systemic stresses or disruptions.           barely dry on Dodd-Frank, we have            in the equity markets may amount to
  So it is ironic, and perhaps unfair, that     ‘Mifid 2’ on the horizon in European         shooting at the wrong target.
when regulators undertake substantial           markets, and an emerging conversation          While FX market participants are con-
reforms elsewhere in capital markets — as       around new equity market reforms in the      cerned about the same issues as those
is the case today with proposed restruc-        US. In both Europe and the US, this          trading in other markets — such as
turing of markets for equities,                             next round of structural         liquidity, pricing transparency, counter-
structured credit and deriva-                               reform focuses either directly   party reliability, orderly trading, etc — it
tives — one or more of these                                or indirectly on high-fre-       should be remembered that FX markets
FX markets often run the risk                               quency trading (HFT) and by      exist not alongside other markets, but in
of being snapped off and placed                             implication, the hedge funds     service to those other markets. As Scha-
into regulatory regimes tai-                                that engage in the practice.     piro has pointed out, the equity markets
lored to other asset classes.                                 A common perception is         primarily serve the formation of capital.
  When the EU Markets in                                    that for equity markets, there   Forex markets, on the other hand, facili-
Financial Instruments Direc-                                is something inherently desta-   tate the movement of this capital.
tive (Mifid) was enacted into                                bilising or even dangerous
law in 2007, it was unclear        Chip Lowry                about HFT. This perspective     Taking a closer look at the markets
until the last minute if FX                                  was particularly exacerbated    It is difficult to precisely identify the impact
would be affected. While the legislation        by the May 6, 2010, ‘flash crash’ that saw   of HFT in the FX markets. As a globally
initially focused on other asset classes, it    the Dow Jones Industrial Average plunge      dispersed market, currency trading statis-
was presumed by many to have broad              some 600 points only to recover those        tics can be an inexact science. But none of
implications for the FX market as it related    losses within minutes. While no defini-      the most informed FX market experts
to equity trading and best execution.           tive explanation for this market event has   would estimate HFT accounting for any-
  Now, with the recent passage of the           been established, directional bets and       where near the 70% of trading volumes that
Dodd-Frank Wall Street Reform and               HFT have been included on the list of        have been seen in the equity market.
Consumer Protection Act in the US, the          possible triggers.                             The most recent BIS survey notes that
market is waiting to see how the Secre-           Concerns over the impact of HFT on         “other financial institutions” have played
tary of the Treasury will rule on whether       markets were clearly laid out in an August   a material role in the 20% increase in
FX forwards and swaps will be defined as        5 letter to SEC chairman Mary Schapiro       daily FX turnover seen since the most
‘swaps’ under the legislation.                  from US senator Ted Kaufman of Dela-         recent survey in 2007. But, even if one
  However these regulatory structures           ware, in which he called for HFT firms to    were to attribute the entire “other finan-
evolve, it should be borne in mind that         be registered with the Securities and        cial institutions” category from this sur-
for the FX market, and all who partici-         Exchange Commission (SEC). Among             vey to HFT, it would account for             11




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only legitimate conclusion is: “Stupid         very welcome, especially if coupled with a      settlement. With all the FX playing fields
bank, short the shares and call their reg-     deadline. The financial services industry       levelled, the costs will come down and
ulator.” Then we have the emerging mar-        works best with clear rules and deadlines.      the level of control will increase.
kets banks: happy to do USD/TRL,               Operating our infrastructure is an              ■ Pipes and liquidity: the solution to sup-
insist on trading USD/EUR too and              immensely expensive business and there is       porting clearing must be CLS-centric.
then are not CLS members.                      no choice but to work together in order to      Ideally, CLS is at the back end so that any
  In looking at the future for FX infra-       settle transactions. When there is incom-       settlement is netted with all other activity.
structure, understanding the present           plete regulation and no appropriate incen-      Using the existing CLS pipes is likely to
highlights is a salutary lesson. Today,        tives, or disincentives, inefficiencies creep   minimise the cost to build and operate, as
there is no incentive to take part in nor      into the system. Invariably, the cost of        well as time to market.
penalty for not using CLS. At times,           these inefficiencies are transferred to those   ■ Currency coverage: we need to add to
there have been suggestions that CLS           who follow the recommendations.                 CLS the means to deal with more than
would lead to there being two prices in
the market. Well, eight years on, this has
not happened.                                      Operating our infrastructure is an immensely expensive
  At an industry event some years ago, in
                                                   business and there is no choice but to work together in
a forum discussion about how to increase
CLS usage, a senior staffer from the                             order to settle transactions
European Central Bank (ECB) asked why
the CLS users did not get together and
simply agree not to offer a price to non-        So, as our industry experts and the reg-      the 17 currencies it supports today. That
users. An interesting suggestion, but as       ulators consider the future, there are          work is in progress; any help that can be
happy as such an effort might make the         some important considerations:                  given to accelerate it would be welcome.
ECB, we did need to point out that this        ■ Disincentives: at last. Great idea. How-      Potentially, some less-liquid currencies
would bring about some unwanted atten-         ever, two important things need to be           could be settled in a different way from
tion from euro bureaucrats in the anti-        built into the design. First, if there are      the core 17.
trust division. There is no regulatory capi-   disincentives, do they create a level play-       To paraphrase something once said about
tal benefit or penalty either. Any new         ing field? Will the regulators of those         advertising: “regulation is not necessarily a
regulation needs to consider this status       emerging markets banks also have the            good or a bad thing, it depends on the use
quo in the largest FX market, cash trad-       same rules? Second, do not stop at              to which it is put”. A stand-alone FX
ing. In the debate around the treatment of     options. Impose the same approach for           option, Group of 20 country-centric solu-
options, the earliest signals are that there   all FX products; use payment versus pay-        tion regulation would simply add costs to
will be regulatory charges for those not       ment where it is available, use clearing        the industry for limited gain and would be
using a clearing solution. This would be       where there is an extended period before        an opportunity squandered. FX



  9   Where next for high-frequency FX trading?
no more than 48% of the market. Given          During the ‘flash crash’, there were some       kers are taking steps to ensure there is a
that this category includes entities like      strains on individual banks and on CLS,         ‘speed limit’ on the velocity of tickets
central banks, insurance companies and         which were processing ticket volumes on         that can be produced by any high-fre-
pension funds, it would appear that HFT        a scale greater than previously seen.           quency trader over a given period of time.
most likely accounts for 18% at most.          However, the FX market did not crack              As a decentralised structure, the FX
                                               and saw no event analogous to the equity        market is used to fragmentation, and has
Trading infrastructure capacity                market ‘flash crash’.                           even made a virtue of the phenomenon,
One problem the FX markets do share              As a precautionary measure, the FX            providing structures for a variety of par-
with the equity markets is the issue of        trading industry is taking steps to bolster     ticipants including institutional manag-
industry infrastructure capacity. Message      capacity and self-police participants. The      ers, corporate treasurers, inter-bank deal-
traffic (as opposed to tickets) can be a       CLS/Traiana CAS system is an example            ers, and yes, high-frequency traders. In
problem in the low-latency HFT world.          of an industry initiative that will help        just a few years, the FX market has
However, the FX market has seen indi-          reduce the number of tickets banks need         evolved to a level of greater transparency,
vidual platforms respond with appropriate      to process. Banks are upgrading their           access and depth. HFT has been an
constraints to ensure that one errant par-     data pipes to handle even higher volumes        important part of this evolution. Let’s
ticipant does not impact the larger venue.     than the market saw on the date of the          hope this fact is recognised by a wider
  Ticket volumes have also been an issue.      flash crash’. In addition, some prime bro-      audience. FX



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